When it comes to elections, it really is the economy, stupid

By Adam Shell, USA TODAY

NEW YORK
–
No endorsement on the campaign trail is more powerful for a president seeking re-election than a rising stock market, a declining unemployment rate and a feeling on Main Street that things are getting better.

By Jewel Samad, AFP/Getty Images

Frustrated Americans of many different political stripes have protested in 2011 against economic conditions.

Frustrated Americans of many different political stripes have protested in 2011 against economic conditions.

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History shows that President Obama's chances of defeating either of the top Republican challengers, Mitt Romney and Newt Gingrich, might have less to do with what the president says he will do to fix the U.S. economy and more to do with how the nation's business locomotive is performing in the run-up to Election Day.

No post-World War II president has been re-elected when the unemployment rate is rising in the 14 months leading up to the election, data from Strategas Research Partners show. Incumbents who lost when the jobless rate was moving higher include George H.W. Bush in 1992 and Jimmy Carter in 1980. Currently, the job market is firming. Unemployment fell to 8.5% in December, down from 9% in October.

"People vote their pocketbooks," says Brian Belski, chief investment strategist at Oppenheimer. "The election is about the economy. If people are feeling better they figure, 'Why switch it up?' "

On the flip side, if stocks swoon, the economy tanks and unemployment lines grow, the door opens for voters to consider a political alternative to Obama on Nov. 6. "Voters will say, 'If Obama can't fix it, who is the next guy to fix it?' " Belski says.

Right now economic momentum is picking up. The latest readings on initial jobless claims and orders for pricey goods with long life spans, such as refrigerators and ovens, have come in better than expected. The data have also been more upbeat on home builders' confidence, manufacturing, auto sales and construction spending. The better news has helped the stock market, which is up 4.7% in January after a flat 2011.

A debate is raging as to which candidate has the best plan to trim the country's ballooning deficit, get the economy to grow, put Americans back to work and revive the housing market.

But before placing investment bets based on election predictions, Wall Street handicappers are looking through the prism of history to see what factors might determine who wins. History says the trajectory of the economy during an election year plays a huge role.

What the numbers indicate

Right now, the presidency appears up for grabs. Some analysts say the race for the White House may come down to jobs. Dan Clifton, an investment strategist who analyzes Washington politics for Strategas, is using a simple prediction strategy tied directly to the percentage of Americans out of work.

"If the unemployment rate climbs above 9%, Obama will lose," Clifton says. "If it drops to 8% the probability of victory goes up, because the president can say that the economy is moving in the right direction. But if the jobless rate stays where it is at 8.5%, it's probably a tossup."

The early polls also point to a close race. Obama has a 54% chance of being re-elected, according to Intrade.com, an online prediction market. Taking into account margin of error, the election outcome is basically 50-50.

That raises a key question: What is Wall Street looking for in a president — and lawmakers in Congress — at a time when the USA is facing one of its biggest fiscal challenges ever and huge decisions loom on key issues, such as deficit reduction, tax policy, the role of government, the size of entitlement programs, job creation, and health care and energy policy?

"It will be a close election that will boil down to who can provide hope and persuade the country (that his policies) will move us in the right direction," says Andrew Busch, public policy strategist at BMO Capital Markets. "We have to decide if we are going to become more like Europe or revert back to what made this country what it is, which is free-market capitalism."

Adds David Kelly, chief market strategist at JPMorgan Funds: "The election will be a referendum on how you want to bring down the deficit." Other analysts say the election is also a referendum on capitalism, free markets and the role of government.

Republicans and Democrats remain far apart on key issues. Republicans, including both Romney, who lost his front-runner luster by losing the South Carolina primary, and Gingrich, blame Obama and the Democrats for stifling the economy with too many regulations, too much government spending and too many growth-choking policy prescriptions, such as favoring higher taxes on businesses and the wealthy.

Democrats rail on Republicans for catering to Wall Street and the wealthy. Obama criticizes Republicans for doing too little to help middle-class Americans who are finding it difficult to make ends meet.

In last week's State of the Union address, Obama outlined his agenda to fix the economy. He wants the wealthy to pay more taxes. He wants to make it easier for homeowners who owe more than their homes are worth to refinance their mortgages at lower rates. He also wants to reward companies that bring jobs back home with lower taxes. And he wants to use the government more to help the struggling middle class.

Economic differences by party

Unlike Obama, the Republicans believe the less government intervention, the better it is for markets and the economy.

Romney pledges to lower taxes on investment gains and corporations to spur growth. He also wants to do away with expensive Obama-driven programs, such as the regulation-heavy Wall Street reform act and health care legislation dubbed ObamaCare.

Similarly, Gingrich, who is highlighting his conservatism during the Republican nomination process, also favors a pro-growth strategy. He wants to make the Bush tax cuts, which expire at year's end, permanent. He also wants to eliminate the capital gains tax and dramatically reduce corporate income tax rates. Getting rid of a slew of regulations that he says are hurting business and job creation is also a priority.

Long-term consequences

With the nation's debt now above $15 trillion, a level deemed unsustainable, the November election is shaping up to be the most important vote in more than 30 years, says Barry Knapp, head of U.S. equity strategy at Barclays Capital.

"Not since the (Ronald) Reagan vs. (Jimmy) Carter election in 1980 have the stakes been so high for the markets and economy," Knapp says.

While the short-term direction of the economy may determine the next U.S. president, the longer-term fate of the markets may be determined by which party grabs power.

"The 2012 elections in the U.S. are likely to hold major consequences for investors," says Jeffrey Kleintop, chief market strategist at LPL Financial: "The party that emerges in control will forge the decisions that will represent one of the biggest shifts in the federal budget policy since World War II." Polls show there is a chance the GOP, which controls the House, might also gain control of the Senate.

"The larger issue for markets," adds Kleintop, "is the race for control of the Senate. A Republican House and Senate (would have) a major impact on the legislation that makes it to the White House. I think the markets prefer the mandate for action that comes from one party in control of Congress, in contrast to the idea that 'gridlock is good.' "

Tobias Levkovich, chief U.S. equity strategist at Citi, says the fact that the USA's rising debt closely mirrors Europe's makes this election critical. "What we are watching across the pond in Europe is a prequel," Levkovich says. "We have kicked the can down the road, but it looks like we are getting close to the end of the road. It's important that the next administration deal with this." If they don't, markets will "become unsettled" as they have in response to the eurozone's debt crisis, he says.

Big decisions hang in the balance

One key policy question that needs to be addressed post-election is whether to extend the Bush-era tax cuts.

Lawmakers must also come up with a plan to cut the deficit after the failure of the congressional super-committee in November. If no action is taken, automatic spending cuts of $1.2 trillion over 10 years will kick in starting in 2013.

"Major decisions need to be made," says Kelly, adding that the big fight will be over whether the best way to reduce the deficit is by cutting government spending or by raising revenue via tax increases. "Knowing more about policy direction will be very good for markets," he says.

If politicians can't get the nation's finances in order, there's a risk that credit-rating agencies will downgrade the nation's rating further. The USA's first-ever downgrade in August from AAA to AA+ roiled markets.

Many on Wall Street view Obama's pro-government approach as "anti-business," says Patrick Adams, of the Dunham Loss Averse fund. "What business doesn't like," he says, "is an increase in regulation and uncertainty." Adams says investors would cheer a Republican president: The Republicans' "policies are more pro-growth."

But Knapp says investors would also be comfortable with Obama reclaiming the White House if Republicans capture the Senate and retain the House. History shows stocks have risen 15% per year, on average, with a Democratic president and Republican-controlled Congress.

Big market moves might not come until later this year when investors have a better read on the election outcome, Knapp adds. The sectors likely to move the most are those most affected by government policy. The list includes health care, defense, energy and financial services.

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